Endowments and Foundations Overlook Investment Risk

Nearly half of the endowments and foundations surveyed indicate an annual loss tolerance of only 5% or less, a figure far exceeded when their portfolios are run through simulations of both the 2002 and 2008 market downturns.

CAPTRUST has published the results of its second annual Endowments & Foundations Survey, compiling the responses of more than 130 organizations that focus on a broad variety of religious, educational and charitable missions.

Of respondents, 64% identified as private, while 36% were public.

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Discussing the findings with PLANSPONSOR, James Stenstrom, senior manager of asset and liability at CAPTRUST, and Eric Bailey, principal and financial adviser at CAPTRUST, say the data shows a clear disconnect surrounding risk appetites and return expectations. Case in point, 72% of respondents indicate their organization’s expected return on assets falls within the 5% to 8% range—which is higher than investment managers were projecting even before the outbreak of the coronavirus pandemic—with 13% expecting returns over 8%.

As endowments and foundations look to increase their returns, it would be reasonable to anticipate an increased tolerance for risk, Stenstrom and Bailey explain. However, the survey shows no significant differences in levels of equity exposure between respondents with moderate and high return expectations. In this sense, endowments and foundations appear to be subject to many of the same misconceptions and challenges hampering individual investors.

In the survey results, the vast majority (91%) of nonprofits indicate an annual loss tolerance of 15% or lower. However, when simulating their asset allocations through the 2008 market crash, each group saw declines in excess of 20%. More troubling, Stenstrom and Bailey observe, nearly half of respondents indicate an annual loss tolerance of only 5% or less, which was far exceeded when run through simulations of both the 2002 and 2008 market downturns.

“These misalignments put endowments and foundations at risk to sustain permanent damage in the event of a major downturn, like the one we are currently experiencing,” Stenstrom warns. “To mitigate any long-term effects, endowments and foundations should develop a playbook for making necessary shifts in asset allocation to limit losses.”

“The first thing about building a playbook like this is to understand the cash flow needs,” Bailey explains. “If you know what the year ahead is going to look like in terms of outflows, and you have that amount in cash or cash equivalents, this will mean you don’t need to tap other assets in a severe downturn.”

It’s also important to look at the donor funding streams and to understand the timing on that side of the balance sheet. Is it state funding? Mostly grants? Are they stable or variable? Are they seasonal?

“Finally, with an organization that is responding to natural disasters, there is no correlation to the current state of the economy,” Bailey says. “On the other hand, for an organization that is funding housing and addressing food insecurity, when there is an economic slump, their needs go up dramatically. Those two types or organizations need very different plans.”

Overall, those organizations willing to tolerate larger annual losses allocate measurably more to equity and other assets, such as alternatives. As the survey shows, 56% of organizations indicate their current portfolio includes an allocation to alternative asset classes. The most common alternatives include real estate (61%), hedge funds (39%) and private investments (35%).

While each organization’s portfolio allocation may not match the potential magnitude of loss, taken as a group, more conservative nonprofits do invest larger proportions of their portfolios in fixed income and cash.

Another enlightening portion of the survey focuses on the perception and use of investments with environmental, social and governance (ESG) themes. While most organizations surveyed (70%) do not currently leverage ESG investing themes, the survey shows that foundations with less than $100 million in assets are much more likely to use ESG funds when compared with larger organizations.

Looking forward, only 2% of respondents plan to reduce their allocation in ESG funds. Half of respondents (51%) are undecided when considering ESG funds, while more than a third of respondents plan to maintain their investments and another 9% plan to increase allocation into the funds.

With half of respondents remaining undecided about their participation in ESG investments for the next year, Stenstrom and Baily observe, it is important to note that many donors have been embracing these funds. Further, a number of national grants are only awarded to foundations that invest in ESG funds, and by not investing in those funds, foundations could be inadvertently restricting which grants they can access.

Beyond the challenges brought about by volatility and lower returns, additional issues respondents point to that could inhibit their organizations in the future include difficulty expanding the donor base, government policies restricting fundraising, competition from other organizations and staffing shortages.

CAPTRUST finds the bulk of organizations exhibit strong governance practices, but room for improvement still exists. For example, fewer than half (43%) of organizations conduct fiduciary training for board or investment committee members, and even fewer (21%) include training on investment-related topics as part of new board member orientation.

Don’t Let Participants Be Surprised by Taxes on Emergency Distributions

State and local tax treatment of coronavirus-related distributions from retirement plans may be different from federal tax treatment.

The Coronavirus Aid, Relief and Economic Security (CARES) Act created a new emergency retirement plan distribution option dubbed the “coronavirus-related distribution,” or “CRD” for short. A CRD can be drawn from an employer-sponsored retirement plan or from individual retirement accounts (IRAs) in any amount up to $100,000. Under the terms of the CARES Act, the normal 10% penalty tax levied on early plan distributions by the IRS is waived. Furthermore, the individual taking a CRD can spread the reported income over three years for tax purposes, and the distribution also can be repaid within three years to avoid taxation.

But a law alert from global law firm Eversheds Sutherland suggests retirement plan sponsors warn participants that state and local tax treatment of these distributions may be different. Adam Cohen, partner at the firm and leader of its employee benefits team, who is based in Washington, D.C., says many of the changes to retirement plan legislation in the past 20 years related more to qualified plan requirements rather than individual taxation of participants. However, the creation of Roth 401(k)s/IRAs in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) is one example of when there was a need for state and local taxation to get in line with federal taxation.

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Following Hurricane Katrina, the Katrina Emergency Tax Relief Act of 2005 (KETRA) also allowed for expanded retirement plan distribution and loan provisions with favorable federal tax treatment, but Cohen says state and local tax treatment was not a big focus since the hurricane only affected participants in a limited number of states.

Cohen explains that many states continuously conform to the Internal Revenue Code, adopting changes as they occur, and others conform as of a specific date and every couple of years the legislature gets together and updates the date as of which the state conforms. He adds that some states may also “pick and choose” what provisions of the federal tax code with which they want to comply.

Of particular note, as Cohen and his co-authors point out in the law alert, “While historically a rolling conformity state, New York’s FY 2021 Budget Act temporarily adopts fixed conformity as of March 1, through January 1, 2022, for purposes of the both the state and New York City personal income taxes.”

The alert notes, “As a result of this fixed conformity, New York became the first state to take action to decouple from the CARES Act, including the three-year ratable income inclusion for coronavirus-related distributions from retirement plans. Therefore, if a plan participant subject to New York income tax takes a coronavirus-related distribution, he or she may be surprised to learn that for New York state and local income tax purposes, the distribution is taxed 100% in 2020, rather than the federal ratable treatment.”

Cohen says, as they have in the past with similar legislation, eventually most state legislatures will conform to federal tax treatment of CRDs, but until they reconvene, it is “up in the air.” He also notes that “in the past, states have recognized the issue will be hard to fix after people file their taxes.”

When legislatures reconvene, “there may be a patchwork of states that conform, but over time, my best guess is it will fill in,” Cohen says.

In the meantime, in communications to plan participants about CRDs, Cohen suggests plan sponsors include language that state tax treatment may vary, or that participants should check with an expert about what state taxes may apply. If plan sponsors want to be more specific, they could look up the law and say what clearly applies in a particular state, but that is harder to do for a “fixed conformity” state. “Communications could say a state doesn’t recognize federal tax treatment at this time but that may change later in the year,” he says.  

One final note Cohen makes is that the same issue exists for the CARES Act provision allowing employers to offer certain help with employee student loan repayments. Under the law, employers can make payments up to $5,250 toward employees’ student loans through end of this year, and the payments do not have to be reported as taxable income for federal income tax purposes. Employers should include warnings about state tax treatment in participant communications about the student loan payments similar to what’s included in communications about CRDs.

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